Applied Industrial Technologies, Inc. (AIT) Q4 2018 Earnings Report, Transcript and Summary

Welcome to the Fiscal 2018 Fourth Quarter and Year-End Earnings Call for Applied Industrial Technologies. My name is Mariana, and I'll be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] Please note this conference is being recorded. I will now turn the call over to Julie Kho. Julie, you may begin.

Thank you and good morning, everyone. This morning was issued our earning release and supplement investor deck detailing latest quarter results. These documents are available on the Investor Relations of our website at applied.com. Our replay of today's broadcast will be available for the next two weeks as noted in the press release. Before we begin, I would like to remind everyone that we'll discuss Applied's business outlook during the conference call and make statements that are considered forward-looking. All forward-looking statements, including those made during the question-and-answer portion, speak only as of the date hereof and are based on current expectations that are subject to certain risks, including trends in various industry sectors and geographies, the success of our various business strategies and other risk factors provided in our press release and identified in Applied's most recent periodic report and other filings made with the SEC, which are available at the Investor Relations section of our website at applied.com. Accordingly, actual results may differ materially from those expressed in the forward-looking statements. The Company undertakes no obligation to update publicly or revise any forward-looking statements, whether due to new information or events or otherwise. In addition, the conference call includes the use of non-GAAP financial measures. These measures are explained in our press release and in the supplemental presentation material and are subject to the qualifications referenced in those documents. In compliance with SEC Regulation FD, this teleconference is being made available to the media and the general public as well as to analysts and investors. Because the teleconference and its webcast are open to all constituents and prior notification has been widely and unselectively disseminated, all content of the call will be considered fully disclosed. Our speakers today include Neil Schrimsher, Applied's President and Chief Executive Officer; and Dave Wells, our Chief Financial Officer. I will now turn the call over to Neil.

Thank you, Julie, and good morning, everyone. We appreciate you joining us. I'll begin with a brief summary of our results for the quarter and full-year. Our net sales for the fourth quarter grew 31.7% to $897.7 million from $681.5 million in the same quarter a year-ago. Net income for the quarter was 40.4 million or $1.03 per share compared with $52.9 million or $1.34 per share in the fourth quarter of fiscal 2017. As noted in our press release and supplemental financial deck, prior year results include a favorable non-routine tax benefit of $22.2 million or $0.56 per share. Excluding this benefit, fourth quarter fiscal 2018 EPS increased 32.1% compared to the prior year. EBITDA for the quarter was a record $87 million or 9.7% of sales up 48.9% from the prior year quarter. Net sales for the full-year were a record $3.07 billion an increase of 18.5% compared with $2.59 billion last year. Net income for our full fiscal year was $141.6 million or $3.61 per share. Adjusted EPS exclusive of $0.13 per share one-time FCX transaction related charges was $3.74 per share. This represents a 31.6% increase compared to adjusted EPS of $2.84 in fiscal 2017 which excludes the non-routine tax benefit mentioned previously. Overall fiscal 2018 proved to be an exciting and successful year with our 95-year anniversary celebration as the backdrop, we are very pleased with our record financial performance and continued progress in enhancing our differentiation as a value added industrial distributor. Through our dedicated associates, enhanced business systems, strategic investments, and best-in-class suppliers, we continue to strengthen our capabilities including our critical core products offering, expanding value added services, leadership in engineered fluid power, and flow control solutions, growing geographic reach and channels to market. Additionally, our FCX Performance team members continue to demonstrate strong customer focus and engagement and we are extremely pleased with our progress today. Across our organization, we are excited for the new fiscal year and the opportunities to drive continuous improvements and further grow our business with current customers and new end users. Now at this time, I'll turn the call over to Dave for a closer look at our financial results.

Thanks Neil, and good morning everyone. I will begin with further details on our most recent quarter financial performance and then briefly further recap full-year 2018 results. After that, I will move on to provide some insight on our fiscal year 2019 outlook. As a reminder, the supplemental investor deck issued this morning recapping key financial performance talking points is available for your additional information. As Neil mentioned, sales for the quarter ending June 2018 increased 31.7% over the prior year quarter. Organically, our topline grew 9.3% inclusive of a 1.1% benefit from the one half incremental selling day in this year's fourth quarter. Acquisitions increased sales by 22.1% while the impact of foreign currency exchange added another 30 basis points of favorability. Exclude the impact of the FCX Performance acquisition, sales per day increased 2% sequentially from the quarter ending March 2018. Fourth quarter sales in our Service Center-Based Distribution segment increased by $58 million or 10.2% year-over-year. Acquisitions within this segment increased sales by 20 basis points and foreign currency fluctuations had a favorable impact of 30 basis points. Excluding the impact of acquisitions and currency translation, sales increased by 9.7%, driven by an 8.5% days adjusted organic increase and 1.2% benefit from the incremental half business day in this year's quarter. Moving to our fluid Power and Flow Control segment, fourth quarter sales increased $159 million or 133.8% as compared to prior year. Acquisitions within this segment, namely the addition of FCX performance generated 126.1% of the year-over-year segment growth. Excluding the impact of acquisitions, the segment generated 7.7% organic sales growth for the quarter inclusive of an 80 basis point benefit from the differential and selling days year-over-year. From a geographic perspective, sales in the quarter for our U.S. operations were up $199 million, or 34.4% year-over-year with acquisitions driving an increase of 25.9%. Excluding acquisition impact, sales from U.S. operations increased by 8.5% comprised of 7.7% days adjusted organic growth, and 0.8% benefit from the incremental half sales day in the quarter. Sales from our businesses outside of the United States, which increased 17% versus the prior your quarter grew 14.2% organically with strong performance across all geographies and represented a balance of the increase over prior year sales. Moving on to gross margins. Our gross profit percentage for the quarter was 29.4%, up 60 basis points year-over-year. Our first full quarter of FCX acquisition results drove 80 basis points of margin expansion year-over-year. Excluding the accretive benefit of the FCX acquisition, gross profit margin for the core business was 28.6%. While this was 20 basis points lower than the prior year quarter I will remind everyone that our prior year fourth quarter comp included a net 50 basis point benefit to gross margins from LIFO layer liquidation. We are pleased that our gross margin performance excluding FCX results improved 28 basis points sequentially driven by our various margin improvement initiatives. Additionally, if we look at the last two quarters of fiscal 2018 our second half results reflect a 10 basis point expansion in organic margins despite the LIFO income benefit recognized in the prior year. Our selling, distribution and administrative expenses on an absolute basis increased $45 million, or 30.6% when compared to the same quarter in the prior year. Acquired businesses accounted for 26.9% year-over-year growth, while fluctuations in foreign currency rates increased SG&A for the quarter by 40 basis points compared to the prior year quarter. Excluding the impact of acquisitions and currency translation, SG&A spend for the quarter increased only 3.3% year-over-year, driven primarily by the impact of annual merit increases and higher performance based incentives. Resulting EBITDA for the quarter was $87 million or 9.7% of sales. Excluding the impact of the FCX performance acquisition despite the tough year-over-year gross margin comps leverage of incremental volumes and continued diligence in SG&A spend help to drive a 19.4% flow through to pretax income on incremental year-over-year volume in the legacy business. In line with our guidance the effective income tax rate was 33% for the quarter as we completed to finally measurement of certain deferred taxes from the blended 28% fiscal year 2018 rate to the go forward 21% U.S. statutory rate. We now expect our effective tax rate for the upcoming fiscal year 2019 to be in the range of 24% to 26% as we fully step down to the lower U.S. statutory rate. Our consolidated balance sheet remains strong wish shareholders' equity of $815 million. Following the culmination of FCX performance transaction and borrowing to fund the acquisition. Our capital allocation priorities remain focused on de-levering and continuing to increase shareholder value by maintaining our track record of consistent dividend payments. As such there was no share repurchase activity in the quarter and we stay no other $68 million of the initial $112.5 million revolver draw, taken to fund the FCX Performance acquisition, bringing our outstanding revolver draw to $19.5 million and leverage to 2.9 times EBITDA under the current credit facility covenants. Cash generated from operating activities was $99.4 million for the quarter, $13.3 million improved from the prior year quarter. Fourth quarter results demonstrated continued traction generated by operating working capital management initiatives. Strong quarter performance include the benefit of a $15 million reduction in inventories and 280 basis point reduction in past due customer receivables in the legacy business. To recap, our fourth quarter performance reflects success from continued execution of our strategic priorities. Looking at the result in fiscal year 2018 highlights as context for fiscal year 2019 guidelines, we had record revenues of $3.1 billion up 18.5% inclusive of the five months of FCX Performance results and up 8.3% excluding acquisitions. Continued execution on gross margin expansion initiatives combined with leverage of our systems investments and operational excellence initiatives drove 18.5% relative to pretax income on incremental volumes exclusive of the impact of the FCX acquisition. EBITDA for the year of $278 million was 9% of sales inclusive of a 20 basis point dilutive impact of one-time FCX acquisition charges. Finally, fiscal 2018 adjusted EPS of $3.74 per share which excludes the $0.13 dilutive impact of the FCX acquisition one-time cost increased to 32% year-over-year as compared to fiscal 2017 adjusted EPS of $2.84 per share which excludes the non-routine tax benefit previously noted. Our 2018 was a record year on many fronts and we look forward to building on this momentum as we move into fiscal 2019. Transitioning now to our outlook for fiscal 2019, as noted in our press release, we are forecasting a sales increase in the range of 16% to 18% and expect earnings per share in the range of $4.48 to $4.68 per share. Full-year impact of the FCX acquisition coupled with growth in the new flow control space drives a portion of this growth. Excluding FCX, sales from our legacy operations are forecast to be in the range of up 5% to up 7% year-over-year. Our EPS guidance reflects a year-over-year increase in the range of 24% to 30%. The non-repeat of one-time costs associated with the FCX acquisition of $0.13 per share coupled with approximately $0.20 per share benefit from an inclusion of a full-year of FCX results generate a portion of this year-over-year increase. The fiscal 2019 forecast also reflects an approximate $0.30 per share benefit from the step down to the new U.S. statutory tax rate from the fiscal 2018 blended rate coupled with an operational improvements of $0.24 to $0.44 per share driven by continued sales growth, margin expansion and productivity initiatives as well as execution on FCX acquisition synergy opportunities. As previously noted, we anticipate that our effective tax rate will be in the 24% to 26% range for the 2019 fiscal year. Cash provided from operations in fiscal 2019 is projected to reflect further traction from our collections and inventory initiatives coupled with the incremental benefit of the lower U.S. tax rate resulting in anticipated cash generated from operations in the range of $230 million to $250 million. Capital expenditures are expected to be in the range of $26 million to $28 million for the coming year. Combined non-cash depreciation and amortization expense would total nearly $88 million for fiscal 2019. Additionally, full-year interest expense is projected to range from $43 million to $44 million. Our capital allocation priorities will continue to focus on delevering and continuing to increase shareholder value by maintaining our track record of consistent dividend payments as well as executing on accretive acquisitions in our strategic served markets. In summary, we are pleased with our progress in fiscal year 2018 and look forward to continuing that momentum and execution into fiscal 2019. With that, I will now turn the call back over to Neil for some further insight on our longer term strategic vision and projections along with some final comments.

Thanks Dave. At 95 years Applied as well-positioned as the technical MRO distribution leader. With our working together, winning together mindset we remain committed to building on our strong foundation and leveraging our expanding capabilities to further generate benefits for all our stakeholders. Our collective execution of our long range strategic plan will propel us forward to achieving our new five-year 2023 objectives including growing revenues to greater than $4.5 billion through mid single-digit organic growth and accretive acquisitions adding an average of $100 million in sales per year, resulting and compound growth approaching 9% over the five years strategic plan horizon. And improving our EBITDA margin to greater than 11% to sales and margin expansion including continued focus on accretive value added services and expansionary products. Leveraging our system investments and operational excellence initiatives and continuing our cost discipline. With our long range objectives in mind we are maintaining continuity in our five strategic elements to generate profitable growth. Core growth, growing our core sales and marketing capabilities across our 600 plus locations, leveraging our local presence to expand with existing accounts and new customers. Product expansion driving result beyond our base offerings with opportunities across all our product groups including maintenance supplies and solutions and value added services, Fluid Power and Flow Control building up on our North American leadership, leveraging our value added services and expanded product offering for OEM customers and gaining increase share of MRO end users. And operational excellence driving continuous improvement across the business and realizing the full potential from our enhanced systems. And finally, acquisitions staying active in extending our business reach and expanding Applied's capabilities to serve industrial customers in our geographic markets. We are confident we will continue to build upon our strong foundation and are accelerating momentum, generating ongoing success and value for all our stakeholders. With that, we will now open up the lines for your questions.

Thank you. We will now begin the question-and-answer session. [Operator Instructions] Your first question comes from Adam Uhlman with Cleveland Research. Your line is open.

Hey, everybody. Good morning. Congrats on the - all the new records.

Thanks Adam.

Thanks Adam.

I wanted to start with the - the guidance for this next fiscal year. Could you talk about your expectations for your organic gross margin performance and how we should be thinking about the FCX business and their gross profit performance?

Sure. Starting with the organic gross margin performance we had very good attraction as we looked at the back half of 2018 despite some of the material cost increases as we caught up with those. We would expect in - as we've talked about continue to target 10 to 20 basis point margin expansion in the core business, then you think about the accretive benefit of the FCX results we had socialized a $0.10 to $0.20 per share EPS impact as we talked about the ‘19 projections for FCX as we culminated the transaction. We've talked I think, in the past about [indiscernible] or so lower amortization around the midpoint assumption there. So we're seeing some improved volume and some margin performance right at the target expectations with the - you kind of mid-33.5% to 34% on the FCX margins which here again mixes up a bit driving to expectations for the EPS for the FCX contribution. Between the amortization true-up and actual results there plus the slightly improved performance in the kind of 26% to 27% EPS range.

Okay. Gotcha. And then within that, I guess, I think I heard you say that amortization is expected to be $88 million for this next fiscal year, did I hear that correctly?

That's combination of depreciation and amortization, both D&A.

Okay. And that compares to the $16 million that you had in the fourth quarter.

So we had $32 million of amortization. I'm sorry I'm looking at a full-year number. Yes, that's correct.

So why would amortization be stepping up so much this next year?

Okay. So the 88 here again was depreciation and amortization.

Okay. Gotcha. I'll follow-up offline on that. Thanks.

[Operator Instructions] Your next question comes from Ryan Cieslak with Northcoast Research. Your line is open.

Hey. Good morning, guys.

Good morning, Ryan.

Hi Ryan.

I just wanted to start it off on the organic growth coming off of again another nice quarter of 8% organic growth on a daily basis. Just maybe if you can talk us through how initial your first quarter trends are looking, I know comps are getting more difficult, but any thoughts on how maybe July and early August has shaped up for you guys from an organic growth standpoint?

I'd say July has really continued as expected upper single-digits increase year-over-year, sequentially some step down right, as we get fiscal year end and quarter year end comparisons, and also considering business seasonality and plant shutdowns that it can occur in July, and August really starting off as expected to for the handful of days that were into the month.

Okay, great. And then Neil fluid power continues to show some nice growth, but it was below what I was looking for here in the quarter, I think maybe below just normal sequential trends as well. Anything happening in this quarter or something that you would call out maybe relative to your expectations that has stood out to you that maybe wasn't as strong as you would have thought or is there something that I'm missing there?

Well I think maybe Dave will touch on right, and we've talked in the past on some of the segment changes and classifications that maybe influenced that comparison. As I look at the fluid power business within the period. I'd see double-digit growth with those operating companies, 10% plus. I would say over 80% of the groups are performing at or exceeding their plans. If I look at the backlog year-over-year, it's up 20% and so right they would have finished the year teens positive year-over-year and continuing momentum going in. And if I look at the projects and the work that we're doing for our customers, and we've got a lot of active involvement in how we're enhancing precision machine control and also energy saving type sustainability projects that help on the MRO aftermarket side for customers as well. So hey, we like where we're at and the progress that's going on in fluid power.

And just elaborate Ryan, we’re getting a little bit of noise from the prior year pro forma work as we cleaned up the statement. So as we would look at the fluid power business like year-over-year from the business and reporting management reporting standpoint. As Neil indicated, double-digit growth and still looking at the backlog position that is up 20% year-over-year. So still very solid fundamentals there against the tougher comps.

Okay. And then the last one for me and I'll hop back in. Any update on how to think about the targeted synergies you guys had laid out earlier in the year with us, you actually think it was around $30 million or so. If you had to think about how that flows through here into fiscal 2019, and maybe just again, some progress or update on progress with what you're seeing there, that would be great.

You bet. So thinking we socialize $30 million share point of synergies over the five-year horizon, we've talked about those being not equally weighted. So 40% or so coming in the first half of that five-year 60% and the back half, thinking we're pleased we're tracking to expectations I think as we talked last quarter we've got the 18 integration and synergy work streams and continue to be very pleased with the energy in the traction on the execution there. So I think we're right in line with expectations there you're seeing that flow through to some improvement in terms of the 19 EPS as I indicated contribution from the FCX business.

Okay. Thanks guys. I'll get back in line.

You bet.

Your next question comes from David Stratton with Great Lakes Review. Your line is open.

Good morning and thank you taking the question.

Good morning.

When we look at your 30 industry groups, I was wondering if you could give some detail there on what you're seeing and then also broader speaking some of the puts and takes of the end market up take care experiencing right now.

Yes. If we look back at the quarter on those industries we would had 22 with increases I think up a little bit from the prior quarter. Applied continued positives that we see around primary fabricated metals oil and gas, aggregate, machinery OEMs, Chemicals and food. So I think consistent those that are doing well continue with strength and maybe it's broadening in the sectors. And if I think about industrial production overall I think we're seeing those increases really broadly across all of those segments and we're seeing that in our results

And then can you break out any impact that you're seeing from either currently and acted tariffs or maybe future tariffs that have been talked about in the new is recently any impact there and I should take into consideration.

Yes. I don't know if I can touch on all the recent ones time to be able to keep up, but I would say with what we are seeing I think we've done a very effective job and I think that's reflective and our margins as we look back and as we move through this portion of the calendar year I mean no doubt. We suppliers on the 232 tariffs on steel and aluminum, we see the impact on some direct imported materials or indirectly on pricing around U.S. produce commodities. And then on the 301 tariffs are those 800 plus different groups that would be impacting some of our supplier base. Directly ourselves I mean we're very low direct importer from China, but we see that coming in and I think we've done and effective job recognizing that inflation in products and ourselves to the marketplace.

Great. Thank you. And then one final and I don't know if I missed this on the call, but did you give CapEx projections for the year?

Yes, we did $26, $28 million is what we have stated is the CapEx expectations for the year.

And I just caller behind the number I like the deployment. I mean we'll some general things at times I don't like. But a lot of that investment will be around shops and services that enhanced productivity or be around technology and systems advancements that further help productivity I think which drives our overall competitiveness and so those things are contributors to how we continue to manage SG&A effectively.

Great. Thanks for insight.

Your next question comes from Steve Barger with KeyBanc Capital Markets. Your line is open.

Hi, good morning, guys.

Good morning, Steve.

Good morning, Steve.

So I was trying to write-down all those numbers as you went through but if I got it right you're thinking free cash flow of maybe $230 million was that works out to.

Get into the range there we talked to $230 million to $250 million of operating cash flow, $26 million to $28 million of CapEx, so to paying on how those fall within the range we could approach the $230 million that would be the high end.

Yes. I mean obviously a big number. I've been trying to just do the math here. I mean, given the cash on hand and the $230 million of free cash flow, you're going to be down at maybe two times net debt to EBITDA at the end of next year if I'm doing the numbers right. Does that mean you're ready to think about acquisitions again? Or how do you think about the balance sheet and the use of cash?

The interest projection I gave you does assume that we would stay in the kind of the two areas that we just dipped to as we went to the 2.9 times net leverage under the credit facilities. So we would continue to - as we've talked, look at bolt-on acquisitions in line with our strategic objectives. And as we've talked keeping the balance sheet being put to use and ultimate long-term target of kind of mid 2s in terms of the leverage ratio going forward to strike that balance.

So I'd say Steve, we have continued to be active in M&A. We work our priorities. We have a productive pipeline and we'd have prospects or targets in ongoing continuing dialogue, but also valuation and diligence as well. So we haven't paused, we've remained active, and as we go through this fiscal year we expect to close acquisitions.

Okay. Just thinking about the guidance, if the implied incremental operating contribution margin for the year I think is in the mid-to-high 9% range. Are there any one-time costs or higher costs that you're not thinking about being able to capture embedded in that guidance? It just seems a little conservative given the growth.

Again, we're still lapping, you stopping about it, there seven months of economic amortization expense FCX embedded there. So if we look organically, we're going to mid-teens in terms of the core AIT business. If you are looking at when that does include SG&A stepping up a bit more beyond just the merits to 3.6% as we think about making some growth investments on customer facing resource to drive some incremental volume and pursue some opportunities that we see. So it does allow for some of that growth investment on the SG&A side, 10 to 20 basis points of core margin expansion. As we think about the FCX business, I think kind of the best way to think about. If we look at the incremental EBITDA year-over-year there seven, you've got full 12 months just five, actually 17.5% flow through on the EBITDA contribution. So once we lap those one-time amortization - the amortization cost, obviously we're going to see that flow through mix up as we talked about last quarter with the more accretive margins that we see on the FCX side of the business.

Yes. For the organic growth in the quarter, how much was priced and how much is built into the outlook, whether the five to seven or the 17% total sales growth?

So we touched on some of the inflation that we're seeing before and for us I think said it, so we'll say it again. In our break/fix MRO would have about a third of our skews that repeat over the year. So that you can get a real tight price measurement in that, two thirds either because of break/fix they are part of some subassembly or a part of equipment going into a service, you may not have a perfect match coming in. With that said, our belief is we've had price input to sales at about 1.5% probably not 2%. As we think going forward, it could continue at that level or it might increase. And I think that as we think about over the full fiscal year will play out. We just know or believe today we're performing well, and if it increases, we know how to operate, if it moderates then we know how to operate in that environment also.

Understood. Very good. Thanks.

Your next question comes from Ryan Cieslak with Northcoast Research. Your line is open.

Thanks guys. Just a couple of follow-up questions for you. Wanted to just maybe touch on the oil and gas businesses following the 2014 acquisitions and sort of where they stand today as a percentage of your revenue. Obviously, I would think that those businesses contributed to some nice growth for you guys on an organic basis in fiscal 2018. What's the expectation does embed in your guidance for those businesses going into 2019 at this point.

They back at quarter right they would have formed mid upper teens year-over-year and positive for the full-year almost 30%. So nice activity and performance and looking back and this year we've done a nice upgrade of bringing them on to ERP systems as well which will serve us very well going forward and we love the markets and deposits in play that they participating and obviously including the Permian. As we think about 2019 in those businesses, expectations again our mid-teens. We think we've got a lot of capability there also value added services to build on and some nice momentum. So that would be our expectations as we look at the fiscal year coming forward.

Okay. And I know there's been a lot of headlines, coming out of the Permian as it relates to maybe some constraints on takeaway capacity. Remind us if that is any - would that have any impact on you guys in terms of what you're selling into there or what your thoughts around that and maybe what you're seeing as well at this point?

Well, I think what we're seeing right now is there's still very good activity there could be more right. I mean I think the Permian at lot $3.2 million plus barrels a day. It probably could grow will grow to $5.5 million a day by 2023 to help that capacity needs to improve which is as they look at pipelines going to Corpus are going Houston and that's going to be very good for FCX in that business. But also as that moves to more artificial lift extraction and requiring more mechanical parts that's good for our business and the service connected around that. So it's a large producing area right if it stand on its own if it was part of OPEC I think would the second largest producer by Saudi So a lot of output coming through and I'm just a believer that market response and those capacity constraints will get addressed in time but it's still a productive environment right now.

Okay. Good color. And then just a follow-up I just another housekeeping question I wanted to follow-up on Adam's question earlier date with the depreciation and amortization. So I must show in hear in the June quarter the most recent quarter you reported of roughly %61 million of depreciation and amortization is that the right run rate going forward and I am just trying to reconcile the 88 I think full-year guidance that you gave.

So there is some potential upside there is you think about the full year we discussed>

Okay. I'll get back in line. Thanks.

At this time, I am showing we have no further questions. I will now turn the call over to Mr. Schrimsher for any closing remarks.

At this point, I just want to thank everyone for join us today and we look forward to talking to many of you as we move throughout the quarter.

Thank you. Ladies and gentlemen, this concludes today's conference. Thank you for participating. You may now disconnect.